2

PART
Financial Markets
Crisis and Response: Credit Market Turmoil and
the Stock Market Crash of October 2008
The financial crisis that started during the summer of 2007 began
to snowball as the value of mortgage-backed securities on financial
institutions’ balance sheets plummeted. When the House of
Representatives, fearing the wrath of constituents who were angry
about proposals to bail out Wall Street, voted down a $700 billion
bailout package proposed by the Bush administration on Monday,
September 29, 2008, the financial crisis took an even more virulent
turn, despite the bailout package that was passed four days later.
A “flight to quality” drove three-month Treasury bill rates down to
almost zero, rates not seen since the Great Depression of the 1930s.
Credit spreads—an indicator of risk—shot through the roof, with
the gap between Eurodollar and Treasury bill rates (the TED spread)
going from around 40 basis points (0.40 percentage point) before
the financial crisis began to over 450 basis points in mid-October,
the highest value in its history. After earlier sharp declines, the stock
market crashed further, with the week beginning on October 6,
2008, showing the worst weekly decline in U.S. history.
The recent financial crisis illustrates how volatile financial markets
can be. This volatility hit financial consumers directly, leading to
difficulty in getting loans, falling home values, and declining retirement
account values, and putting jobs in jeopardy. How can policy respond
to disruptions in financial markets? We begin addressing this question
by examining the inner workings of financial markets, particularly
interest rate dynamics. Chapter 4 explains what an interest rate is,
as well as the relationships among interest rates, bond prices, and
returns. Chapter 5 examines how the overall level of interest rates is
determined. In Chapter 6, we extend the analysis of the bond market
to explain changes in credit spreads and the relationship of long-term
to short-term interest rates. Chapter 7 looks at the role of expectations
in the stock market and explores what drives stock prices.
 CHAPTER 4 The Meaning of Interest Rates 111

savings account that earns interest and have more than a dollar in one year. Economists
use a more formal definition, as explained in this section.
Let’s look at the simplest kind of debt instrument, which we will call a simple
loan. In this loan, the lender provides the borrower with an amount of funds (called
the principal) that must be repaid to the lender at the maturity date, along with an addi-
tional payment for the interest. For example, if you made your friend, Jane, a simple
loan of $100 for one year, you would require her to repay the principal of $100 in one
year’s time, along with an additional payment for interest—say, $10. In the case of a
simple loan like this one, the interest payment divided by the amount of the loan is
a natural and sensible way to measure the interest rate. This measure of the so-called
simple interest rate, i, is

$10
i = = 0.10 = 10%
$100
If you make this $100 loan, at the end of the year you will have $110, which can
be rewritten as
$100 * 11 + 0.102 = $110
If you then lent out the $110 at the same interest rate, at the end of the second
year you would have
$110 * 11 + 0.102 = $121
or, equivalently,
$100 * (1 + 0.10) * (1 + 0.10) = $100 * 11 + 0.102 2 = $121
Continuing with the loan again, at the end of the third year you would have
$121 * 11 + 0.102 = $100 * 11 + 0.102 3 = $133
Generalizing, we can see that at the end of n years, your $100 would turn into
$100 * 11 + i2 n
The amounts you would have at the end of each year by making the $100 loan
today can be seen in the following timeline:

Today Year Year Year Year

0 1 2 3 n

$100 $110 $121 $133 $100 3 (1 1 0.10)n

This timeline clearly indicates that you are just as happy having $100 today as you
will be having $110 a year from now (of course, as long as you are sure that Jane will
pay you back). You are also just as happy having $100 today as you will be having $121
two years from now, or $133 three years from now, or 100 * 11 + 0.102 n dollars n
years from now. The timeline indicates that we can also work backward from future
amounts to the present. For example, $133 = $100 * 11 + 0.102 3 three years from
now is worth $100 today, so
$133
$100 =
11 + 0.102 3
112 PART 2 Financial Markets

The process of calculating today’s value of dollars received in the future, as we have
done above, is called discounting the future. We can generalize this process by writing
today’s (present) value of $100 as PV and the future cash flow (payment) of $133 as CF,
and then replacing 0.10 (the 10% interest rate) by i. This leads to the following formula:
CF
PV = (1)
(1 + i)n
Intuitively, Equation 1 tells us that if you are promised $1 of cash flow, for cer-
tain, ten years from now, this dollar would not be as valuable to you as $1 is today
because, if you had the $1 today, you could invest it and end up with more than $1
in ten years.
The concept of present value is extremely useful, because it allows us to figure out
today’s value (price) of a credit (debt) market instrument at a given simple interest rate i
by just adding up the individual present values of all the future payments received. This
information enables us to compare the values of two or more instruments that have very
different timing of their payments.

APP L I C AT IO N

What is the present value of $250 to be paid in two years if the interest rate is 15%?
Solution
The present value would be $189.04. We find this value by using Equation 1,
CF
PV =
11 + i2 n

where CF = cash flow in two years = 250

i = annual interest rate = 0.15
n = number of years = 2

Thus
$250 $250
PV = 2 = = $189.04
11 + 0.152 1.3225

Today Year Year

0 1 2

$250
$189.04

APP L I C AT IO N
Assume that you just hit the $20 million jackpot in the New York State Lottery, which
promises you a payment of $1 million every year for the next twenty years. You are
clearly excited, but have you really won $20 million?
 CHAPTER 4 The Meaning of Interest Rates 113

Solution
No, not in the present value sense. In today’s dollars, that $20 million is worth a lot
less. If we assume an interest rate of 10% as in the earlier examples, the first payment
of $1 million is clearly worth $1 million today, but the second payment next year is
worth only $1 million> 11 + 0.102 = $909,090, a lot less than $1 million. The fol-
lowing year, the payment is worth $1 million> 11 + 0.102 2 = $826,446 in today’s
dollars, and so on. When you add up all these amounts, they total $9.4 million. You
are still pretty excited (who wouldn’t be?), but because you understand the concept
of present value, you recognize that you are the victim of false advertising. In present-
value terms, you didn’t really win $20 million, but instead won less than half that
amount. ◆

Four Types of Credit Market Instruments

In terms of the timing of their cash flow payments, there are four basic types of credit
market instruments.
1. A simple loan, which we have already discussed, in which the lender provides the
borrower with an amount of funds that must be repaid to the lender at the maturity
date, along with an additional payment for the interest. Many money market instru-
ments are of this type—for example, commercial loans to businesses.
2. A fixed-payment loan (also called a fully amortized loan) in which the lender
provides the borrower with an amount of funds that the borrower must repay by
making the same payment, consisting of part of the principal and interest, every
period (such as a month) for a set number of years. For example, if you borrow
$1,000, a fixed-payment loan might require you to pay $126 every year for 25 years.
Installment loans (such as auto loans) and mortgages are frequently of the fixed-
payment type.
3. A coupon bond pays the owner of the bond a fixed interest payment (coupon
payment) every year until the maturity date, when a specified final amount
(face value or par value) is repaid. (The coupon payment is so named be-
cause in the past, the bondholder obtained payment by clipping a coupon off
the bond and sending it to the bond issuer, who then sent the payment to the
holder. Today, it is no longer necessary to send in coupons to receive pay-
ments.) A coupon bond with $1,000 face value, for example, might pay you a
coupon payment of $100 per year for ten years, and then repay you the face
value amount of $1,000 at the maturity date. (The face value of a bond is usu-
ally in $1,000 increments.)
A coupon bond is identified by four pieces of information: First is the
bond’s face value; second is the corporation or government agency that issues
the bond; third is the maturity date of the bond; and fourth is the bond’s coupon
rate, which is the dollar amount of the yearly coupon payment expressed as a
percentage of the face value of the bond. In our example, the coupon bond has
a yearly coupon payment of $100 and a face value of $1,000. The coupon rate
is then $100> $1,000 = 0.10, or 10%. Capital market instruments such as U.S.
Treasury bonds and notes and corporate bonds are examples of coupon bonds.
4. A discount bond (also called a zero-coupon bond) is bought at a price below its
face value (at a discount), and the face value is repaid at the maturity date. Unlike a
114 PART 2 Financial Markets

coupon bond, a discount bond does not make any interest payments; it just pays off
the face value. For example, a one-year discount bond with a face value of $1,000
might be bought for $900; in a year’s time, the owner would be repaid the face
value of $1,000. U.S. Treasury bills, U.S. savings bonds, and long-term zero-coupon
bonds are examples of discount bonds.
These four types of instruments make payments at different times: Simple loans
and discount bonds make payments only at their maturity dates, whereas fixed-pay-
ment loans and coupon bonds make payments periodically until maturity. How can
you decide which of these instruments will provide you with the most income? They all
seem so different because they make payments at different times. To solve this problem,
we use the concept of present value, explained earlier, to provide us with a procedure
for measuring interest rates on these different types of instruments.

Yield to Maturity
Of the several common ways of calculating interest rates, the most important is the
yield to maturity, which is the interest rate that equates the present value of cash flow
payments received from a debt instrument with its value today.1 Because the concept
behind the calculation of the yield to maturity makes good economic sense, economists
consider it the most accurate measure of interest rates.
To better understand the yield to maturity, we now look at how it is calculated for the
four types of credit market instruments. In all of these examples, the key to understanding
the calculation of the yield to maturity is realizing that we are equating today’s value of the
debt instrument with the present value of all of its future cash flow payments.

Simple Loan Using the concept of present value, the yield to maturity on a simple loan
is easy to calculate. For the one-year loan we discussed, today’s value is $100, and the pay-
ments in one year’s time would be $110 (the repayment of $100 plus the interest payment
of $10). We can use this information to solve for the yield to maturity i by recognizing that
the present value of the future payments must equal today’s value of the loan.

APP L I C AT IO N
If Pete borrows $100 from his sister and next year she wants $110 back from him,
what is the yield to maturity on this loan?
Solution
The yield to maturity on the loan is 10%.
CF
PV =
11 + i2 n

where PV = amount borrowed = $100

CF = cash flow in one year = $110
n = number of years = 1

1
In other contexts, the yield to maturity is also called the internal rate of return.
 CHAPTER 4 The Meaning of Interest Rates 115

Thus

$110
$100 =
11 + i2
11 + i2 $100 = $110

$110
11 + i2 =
$100
i = 1.10 - 1 = 0.10 = 10%

Today Year
0 1

$100 $110
i 5 10% ◆

This calculation of the yield to maturity should look familiar because it equals the
interest payment of $10 divided by the loan amount of $100; that is, it equals the sim-
ple interest rate on the loan. An important point to recognize is that for simple loans,
the simple interest rate equals the yield to maturity. Hence the same term i is used to
denote both the yield to maturity and the simple interest rate.

Fixed-Payment Loan Recall that this type of loan has the same cash flow payment
every period throughout the life of the loan. On a fixed-rate mortgage, for example, the
borrower makes the same payment to the bank every month until the maturity date, at
which time the loan will be completely paid off. To calculate the yield to maturity for a
fixed-payment loan, we follow the same strategy that we used for the simple loan—we
equate today’s value of the loan with its present value. Because the fixed-payment loan
involves more than one cash flow payment, the present value of the fixed-payment loan
is calculated (using Equation 1) as the sum of the present values of all cash flow
payments.
In the case of our earlier example, the loan is $1,000 and the yearly payment is
$126 for the next 25 years. The present value (PV) is calculated as follows: At the end of
one year, there is a $126 payment with a PV of $126> 11 + i2; at the end of two years,
there is another $126 payment with a PV of $126> 11 + i2 2; and so on until, at the
end of the twenty-fifth year, the last payment of $126 with a PV of $126> 11 + i2 25 is
made. Setting today’s value of the loan ($1,000) equal to the sum of the present values
of all the yearly payments gives us

$126 $126 $126 $126

$1,000 = + 2 + 3 + c +
1 + i 11 + i2 11 + i2 11 + i2 25
More generally, for any fixed-payment loan,

FP FP FP FP
LV = + 2 + 3 + c + (2)
11 + i2 11 + i2 11 + i2 11 + i2 n
116 PART 2 Financial Markets

where LV = loan value

FP = fixed yearly payment
n = number of years until maturity
For a fixed-payment loan, the loan value, the fixed yearly payment, and the num-
ber of years until maturity are known quantities, and only the yield to maturity is
not. So we can solve this equation for the yield to maturity i. Because this calculation
is not easy, many financial calculators have programs that enable you to find i given
the loan’s numbers for LV, FP, and n. For example, in the case of a 25-year $1,000
loan with yearly payments of $85.81, the yield to maturity that results from solv-
ing Equation 2 is 7%. Real estate brokers always have a financial calculator that can
solve such equations handy, so that they can immediately tell the prospective house
buyer exactly what the yearly (or monthly) payments will be if the house purchase is
financed by a mortgage.

APP L I C AT IO N

You decide to purchase a new home and need a $100,000 mortgage. You take out a
loan from the bank that has an interest rate of 7%. What is the yearly payment to the
bank if you wish to pay off the loan in twenty years?

Solution
The yearly payment to the bank is $9,439.29.

FP FP FP FP
LV = + 2 + 3 + c +
11 + i2 11 + i2 11 + i2 11 + i2 n

where LV = loan value amount = 100,000

i = annual interest rate = 0.07
n = number of years = 20

Thus

FP FP FP FP
$100,000 = + 2 + 3 + c +
11 + 0.072 11 + 0.072 11 + 0.072 11 + 0.072 20

To find the monthly payment for the loan using a financial calculator:

n = number of years = 20
PV = amount of the loan 1LV2 = 100,000
FV = amount of the loan after 20 years = 0
i = annual interest rate = 0.07

Then push the PMT button to get the fixed yearly payment 1FP2 = $9,439.29. ◆
 CHAPTER 4 The Meaning of Interest Rates 117

Coupon Bond To calculate the yield to maturity for a coupon bond, follow the
same strategy used for the fixed-payment loan: Equate today’s value of the bond with its
present value. Because coupon bonds also have more than one cash flow payment, the
present value of the bond is calculated as the sum of the present values of all the coupon
payments plus the present value of the final payment of the face value of the bond.
The present value of a $1,000-face-value bond with ten years to maturity and
yearly coupon payments of $100 (a 10% coupon rate) can be calculated as follows:
At the end of one year, there is a $100 coupon payment with a PV of $100> 11 + i2;
at the end of the second year, there is another $100 coupon payment with a PV of
$100> 11 + i2 2; and so on until, at maturity, there is a $100 coupon payment with
a PV of $100> 11 + i2 10 plus the repayment of the $1,000 face value with a PV of
$1,000> 11 + i2 10. Setting today’s value of the bond (its current price, denoted by P)
equal to the sum of the present values of all the cash flow payments for the bond gives

$100 $100 $100 $100 $1,000

P = + 2 + 3 + c + 10 +
1 + i 11 + i2 11 + i2 11 + i2 11 + i2 10
More generally, for any coupon bond,2

C C C C F
P = + 2 + 3 + c + n + (3)
1 + i 11 + i2 11 + i2 11 + i2 11 + i2 n

where P = price of the coupon bond

C = yearly coupon payment
F = face value of the bond
n = years to maturity date
In Equation 3, the coupon payment, the face value, the years to maturity, and the
price of the bond are known quantities, and only the yield to maturity is not. Hence we
can solve this equation for the yield to maturity i. As in the case of the fixed-payment
loan, this calculation is not easy, so business-oriented software and financial calculators
have built-in programs that solve the equation for you.

APP L I C AT IO N

Find the price of a 10% coupon bond with a face value of $1000, a 12.25% yield to
maturity, and eight years to maturity.
Solution
The price of the bond is $889.20. To solve using a financial calculator:
n = years to maturity = 8
FV = face value of the bond 1F2 = 1,000
i = annual interest rate = 12.25%
PMT = yearly coupon payments1C2 = 100
Then push the PV button to get the price of the bond = $889.20.
2
Most coupon bonds actually make coupon payments on a semiannual basis rather than once a year as we assumed
here. The effect on the calculations is very slight and will be ignored here.
118 PART 2 Financial Markets

Alternatively, you could solve for the yield to maturity given the bond price by
entering $889.20 for PV and pushing the i button to get a yield to maturity of 12.25%. ◆

Table 1 shows the yields to maturity calculated for several bond prices. Three
interesting facts emerge:
1. When the coupon bond is priced at its face value, the yield to maturity equals the
coupon rate.
2. The price of a coupon bond and the yield to maturity are negatively related; that
is, as the yield to maturity rises, the price of the bond falls. As the yield to maturity
falls, the price of the bond rises.
3. The yield to maturity is greater than the coupon rate when the bond price is below its
face value and is less than the coupon rate when the bond price is above its face value.
These three facts are true for any coupon bond and are really not surprising if you
think about the reasoning behind the calculation of the yield to maturity. When you
put $1,000 in a bank account with an interest rate of 10%, you can take out $100 every
year and you will be left with the $1,000 at the end of ten years. This process is similar
to buying the $1,000 bond with a 10% coupon rate analyzed in Table 1, which pays
a $100 coupon payment every year and then repays $1,000 at the end of ten years. If
the bond is purchased at the par value of $1,000, its yield to maturity must equal 10%,
which is also equal to the coupon rate of 10%. The same reasoning applied to any cou-
pon bond demonstrates that if the coupon bond is purchased at its par value, the yield
to maturity and the coupon rate must be equal.
It is a straightforward process to show that the bond price and the yield to maturity
are negatively correlated. As i, the yield to maturity, increases, all denominators in the bond
price formula (Equation 3) must necessarily increase, because the rise in i lowers the pres-
ent value of all future cash flow payments for this bond. Hence a rise in the interest rate, as
measured by the yield to maturity, means that the price of the bond must fall. Another way
to explain why the bond price falls when the interest rate rises is to consider that a higher
interest rate implies that the future coupon payments and final payment are worth less when
discounted back to the present; hence the price of the bond must be lower.
The third fact, that the yield to maturity is greater than the coupon rate when the
bond price is below its par value, follows directly from facts 1 and 2. When the yield
to maturity equals the coupon rate, then the bond price is at the face value; when the

TABLE 1 Yields to Maturity on a 10%-Coupon-Rate Bond Maturing

in Ten Years (Face Value = $1,000)
Price of Bond ($) Yield to Maturity (%)
1,200 7.13
1,100 8.48
1,000 10.00
900 11.75
800 13.81
 CHAPTER 4 The Meaning of Interest Rates 119

yield to maturity rises above the coupon rate, the bond price necessarily falls and so
must be below the face value of the bond.
One special case of a coupon bond is worth discussing here because its yield to maturity
is particularly easy to calculate. This bond is called a consol or a perpetuity; it is a per-
petual bond with no maturity date and no repayment of principal that makes fixed coupon
payments of $C forever. Consols were first sold by the British Treasury during the Napole-
onic Wars and are still traded today; they are quite rare, however, in American capital mar-
kets. The formula in Equation 3 for the price of the consol Pc simplifies to the following:3
C
Pc = (4)
ic
where Pc = price of the perpetuity 1consol2
C = yearly payment
ic = yield to maturity of the perpetuity 1consol2
One nice feature of perpetuities is that you can immediately see that as ic increases, the
price of the bond falls. For example, if a perpetuity pays $100 per year forever and the
interest rate is 10%, its price will be $1,000 = $100>0.10. If the interest rate rises to 20%,
its price will fall to $500 = $100>0.20. We can rewrite this formula as

C
ic = (5)
Pc

APP L I C AT IO N

What is the yield to maturity on a bond that has a price of $2,000 and pays $100 of
interest annually, forever?
Solution
The yield to maturity is 5%.
C
ic =
Pc

3
The bond price formula for a consol is
C C C
P = + + + c
1 + i 11 + i2 2
11 + i2 3
which can be written as
P = C1x + x 2 + x 3 + c2
in which x = 1> 11 + i2. The formula for an infinite sum is

1
1 + x + x2 + x3 + c = for x 6 1
1 - x

and so
1 1
P = Ca - 1b = Cc - 1d
1 - x 1 - 1> 11 + i2

which by suitable algebraic manipulation becomes

1 + i i C
P = Ca - b =
i i i
120 PART 2 Financial Markets

where C = yearly payment = $100

Pc = price of perpetuity (consol) = $2,000
Thus

$100
ic =
$2,000
ic = 0.05 = 5% ◆

The formula given in Equation 5, which describes the calculation of the yield to
maturity for a perpetuity, also provides a useful approximation for the yield to maturity
on coupon bonds. When a coupon bond has a long term to maturity (say, twenty years
or more), it is very much like a perpetuity, which pays coupon payments forever. This
is because the cash flows more than twenty years in the future have such small present
discounted values that the value of a long-term coupon bond is very close to the value
of a perpetuity with the same coupon rate. Thus ic in Equation 5 will be very close to the
yield to maturity for any long-term bond. For this reason, ic, the yearly coupon payment
divided by the price of the security, has been given the name current yield and is fre-
quently used as an approximation to describe interest rates on long-term bonds.

Discount Bond The yield-to-maturity calculation for a discount bond is similar to

that for a simple loan. Let’s consider a discount bond such as a one-year U.S. Treasury
bill that pays a face value of $1,000 in one year’s time but today has a price of $900.

APP L I C AT IO N
What is the yield to maturity on a one-year, $1,000 Treasury bill with a current price
of $900?
Solution
The yield to maturity is 11.1%.
Using the present value formula,
CF
PV =
11 + i2 n
and recognizing that the present value (PV) is the current price of $900, the cash flow
in one year is $1,000, and the number of years is 1, we can write:
$1,000
$900 =
1 + i
Solving for i, we get
11 + i2 * $900 = $1,000
$900 + $900i = $1,000
$900i = $1,000 - $900
$1,000 - $900
i = = 0.111 = 11.1% ◆
$900
 CHAPTER 4 The Meaning of Interest Rates 121

As we just saw in the preceding application, the yield to maturity for a one-year
discount bond equals the increase in price over the year, $1,000 − $900, divided by the
initial price, $900. Hence, more generally, for any one-year discount bond, the yield to
maturity can be written as

F - P
i = (6)
P
where F = face value of the discount bond
P = current price of the discount bond
An important feature of this equation is that it indicates that, for a discount bond,
the yield to maturity is negatively related to the current bond price. This is the same
conclusion that we reached for a coupon bond. Equation 6 shows that a rise in the bond
price—say, from $900 to $950—means that the bond will have a smaller increase in
its price at maturity and so the yield to maturity will fall, from 11.1% to 5.3% in our
example. Similarly, a fall in the yield to maturity means that the current price of the
discount bond has risen.

Summary The concept of present value tells you that a dollar in the future is not
as valuable to you as a dollar today because you can earn interest on a dollar you have
today. Specifically, a dollar received n years from now is worth only $1> 11 + i2 n
today. The present value of a set of future cash flow payments on a debt instrument equals
the sum of the present values of each of the future payments. The yield to maturity for an
instrument is the interest rate that equates the present value of the future payments on that
instrument to its value today. Because the procedure for calculating the yield to maturity is
based on sound economic principles, the yield to maturity is the measure that economists
think most accurately describes the interest rate.
Our calculations of the yield to maturity for a variety of bonds reveal the important
fact that current bond prices and interest rates are negatively related: When the interest
rate rises, the price of the bond falls, and vice versa.

THE DISTINCTION BETWEEN INTEREST RATES

AND RETURNS
Many people think that the interest rate on a bond tells them all they need to know
about how well off they are as a result of owning it. If Irving the Investor thinks he is
well off when he owns a long-term bond yielding a 10% interest rate, and the interest
rate then rises to 20%, he will have a rude awakening: As we will shortly see, if he has
to sell the bond, Irving will lose his shirt! How well a person does financially by holding
a bond or any other security over a particular time period is accurately measured by the
security’s return, or, in more precise terminology, the rate of return. We will use the
concept of return continually throughout this book: Understanding this concept will
make the material presented later in the book easier to follow.
For any security, the rate of return is defined as the amount of each payment to
the owner plus the change in the security’s value, expressed as a fraction of its pur-
chase price. To make this definition clearer, let us see what the return would look
like for a $1,000-face-value coupon bond with a coupon rate of 10% that is bought
122 PART 2 Financial Markets

for $1,000, held for one year, and then sold for $1,200. The payments to the owner
are the yearly coupon payments of $100, and the change in the bond’s value is
$1,200 - $1,000 = $200. Adding these values together and expressing them as a
fraction of the purchase price of $1,000 gives us the one-year holding-period return
for this bond:

$100 + $200 $300

= = 0.30 = 30%
$1,000 $1,000
You may have noticed something quite surprising about the return that we just
calculated: It equals 30%, yet as Table 1 indicates, initially the yield to maturity was
only 10%. This discrepancy demonstrates that the return on a bond will not necessar-
ily equal the yield to maturity on that bond. We now see that the distinction between
interest rate and return can be important, although for many securities the two may be
closely related.
More generally, the return on a bond held from time t to time t + 1 can be writ-
ten as

C + Pt + 1 - Pt
R = (7)
Pt
where R = return from holding the bond from time t to time t + 1
Pt = price of the bond at time t
Pt + 1 = price of the bond at time t + 1
C = coupon payment
A convenient way to rewrite the return formula in Equation 7 is to recognize that
it can be split into two separate terms:
C Pt + 1 - Pt
R = +
Pt Pt
The first term is the current yield ic (the coupon payment over the purchase price):
C
= ic
Pt
The second term is the rate of capital gain, or the change in the bond’s price relative
to the initial purchase price:
Pt + 1 - Pt
= g
Pt
where g is the rate of capital gain. Equation 7 can then be rewritten as
R = ic + g (8)

which shows that the return on a bond is the current yield ic plus the rate of capital
gain g. This rewritten formula illustrates the point we just discovered: Even for a bond
for which the current yield ic is an accurate measure of the yield to maturity, the return
can differ substantially from the interest rate. Returns will differ substantially from the
interest rate if the price of the bond experiences sizable fluctuations that produce sub-
stantial capital gains or losses.
 CHAPTER 4 The Meaning of Interest Rates 123

TABLE 2 One-Year Returns on Different-Maturity 10%-Coupon-Rate Bonds When Interest

Rates Rise from 10% to 20%
(1) (2) (4) (5) (6)
Years to Initial (3) Price Rate of Rate of
Maturity Current Initial Next Capital Return
When Bond Yield Price Year* Gain [col (2)
Is Purchased (%) ($) ($) (%) col (5)] (%)
30 10 1,000 503 -49.7 -39.7
20 10 1,000 516 -48.4 -38.4
10 10 1,000 597 -40.3 -30.3
5 10 1,000 741 -25.9 -15.9
2 10 1,000 917 -8.3 +1.7
1 10 1,000 1,000 0.0 +10.0

*Calculated with a financial calculator, using Equation 3.

To explore this point even further, let’s look at what happens to the returns on
bonds of different maturities when interest rates rise. Table 2 calculates the one-year
returns, using Equation 8 above, on several 10%-coupon-rate bonds, all purchased at
par, when interest rates on all these bonds rise from 10% to 20%. Several key findings
from this table are generally true of all bonds:

whose times to maturity are the same as their holding periods (see, for example, the
last bond in Table 2).

losses on bonds whose terms to maturity are longer than their holding periods.

change associated with an interest rate change.

a result of an increase in the interest rate.

out to be negative if interest rates rise.

At first, students are frequently puzzled (as was poor Irving the Investor) that a rise in
interest rates can mean that a bond has been a poor investment. The trick to understanding
this fact is to recognize Irving has already purchased the bond, so that a rise in the interest
rate means that the price of the bond Irving is holding falls and he experiences a capital loss.
If this loss is large enough, the bond can be a poor investment indeed. For example, we see
in Table 2 that the bond that has 30 years to maturity when purchased has a capital loss
of 49.7% when the interest rate rises from 10% to 20%. This loss is so large that it exceeds
the current yield of 10%, resulting in a negative return (loss) of –39.7%. If Irving does not
sell the bond, his capital loss is often referred to as a “paper loss.” This is a loss nonetheless
because if Irving had not bought this bond and had instead put his money in the bank, he
would now be able to buy more bonds at their lower price than he presently owns.
124 PART 2 Financial Markets

Maturity and the Volatility of Bond Returns:

Interest-Rate Risk
The finding that the prices of longer-maturity bonds respond more dramatically to
changes in interest rates helps explain an important fact about the behavior of bond
markets: Prices and returns for long-term bonds are more volatile than those for
shorter-term bonds. Price changes of + 20% and - 20% within a year, with correspond-
ing variations in returns, are common for bonds that are more than twenty years away
from maturity.
We now see that changes in interest rates make investments in long-term bonds
quite risky. Indeed, the risk level associated with an asset’s return that results from
interest-rate changes is so important that it has been given a special name, interest-
rate risk.4 Dealing with interest-rate risk is a major concern of managers of financial
institutions and investors, as we will see in later chapters.
Although long-term debt instruments have substantial interest-rate risk, short-term
debt instruments do not. Indeed, bonds with a maturity term that is as short as the hold-
ing period have no interest-rate risk.5 We see this for the coupon bond at the bottom of
Table 2, which has no uncertainty about the rate of return because it equals the yield to
maturity, which is known at the time the bond is purchased. The key to understanding
why there is no interest-rate risk for any bond whose time to maturity matches the hold-
ing period is to recognize that (in this case) the price at the end of the holding period is
already fixed at the face value. A change in interest rates can then have no effect on the
price at the end of the holding period for these bonds, and the return will therefore be
equal to the yield to maturity, which is known at the time the bond is purchased.6

4
Interest-rate risk can be quantitatively measured using the concept of duration. This concept and its calculation
are discussed in an appendix to this chapter, which can be found on the Companion Website at [Link]
.[Link]/Mishkin.
5
The statement that there is no interest-rate risk for any bond whose time to maturity matches the holding period
is literally true only for discount (zero-coupon) bonds that make no intermediate cash payments before the holding
period is over. A coupon bond that makes an intermediate cash payment before the holding period is over requires
that this payment be reinvested. Because the interest rate at which this payment can be reinvested is uncertain,
some uncertainty exists about the return on this coupon bond even when the time to maturity equals the holding
period. However, the riskiness of the return on a coupon bond from reinvesting the coupon payments is typically
quite small, so a coupon bond with a time to maturity equal to its holding period still has very little risk.
6
In this text we assume that holding periods on all short-term bonds are equal to the term to maturity, and thus the
bonds are not subject to interest-rate risk. However, if the term to maturity of the bond is shorter than an investor’s
holding period, the investor is exposed to a type of interest-rate risk called reinvestment risk. Reinvestment risk occurs
because the proceeds from the short-term bond need to be reinvested at a future interest rate that is uncertain.
To understand reinvestment risk, suppose that Irving the Investor has a holding period of two years and decides
to purchase a $1,000, one-year bond at face value and then another one at the end of the first year. If the initial inter-
est rate is 10%, Irving will have $1,100 at the end of the first year. If the interest rate rises to 20%, as in Table 2,
Irving will find that buying $1,100 worth of another one-year bond will leave him at the end of the second year with
$1,100 * 11 + 0.202 = $1,320. Thus Irving’s two-year return will be 1 $1,320 - $,10002 >1,000 = 0.32 =
32%, which equals 14.9% at an annual rate. In this case, Irving has earned more by buying the one-year bonds than he
would have if he had initially purchased a two-year bond with an interest rate of 10%. Thus, when Irving has a hold-
ing period that is longer than the term to maturity of the bonds he purchases, he benefits from a rise in interest rates.
Conversely, if interest rates fall to 5%, Irving will have only $1,155 at the end of two years: $1,100 * 11 + 0.052.
His two-year return will be 1$1,555 - $1,0002 >1,000 = 0.155 = 15.5%, which is 7.2% at an annual rate. With a
holding period greater than the term to maturity of the bond, Irving now loses from a decline in interest rates.
We have seen that when the holding period is longer than the term to maturity of a bond, the return is uncer-
tain because the future interest rate when reinvestment occurs is also uncertain—in short, there is reinvestment
risk. We also see that if the holding period is longer than the term to maturity of the bond, the investor benefits
from a rise in interest rates and is hurt by a fall in interest rates.
 CHAPTER 4 The Meaning of Interest Rates 125

Summary
The return on a bond, which tells you how good an investment it has been over the
holding period, is equal to the yield to maturity in only one special case—when the
holding period and the term to maturity of the bond are identical. Bonds whose terms
to maturity are longer than their holding periods are subject to interest-rate risk:
Changes in interest rates lead to capital gains and losses that produce substantial differ-
ences between the return and the yield to maturity known at the time the bond is pur-
chased. Interest-rate risk is especially important for long-term bonds, on which capital
gains and losses can be substantial. This is why long-term bonds are not considered safe
assets with a sure return over short holding periods.

THE DISTINCTION BETWEEN REAL AND NOMINAL

INTEREST RATES
So far in our discussion of interest rates, we have ignored the effects of inflation on the
cost of borrowing. What we up to this point have been calling the interest rate makes
no allowance for inflation, and it is more precisely referred to as the nominal interest
rate. We must distinguish the nominal interest rate from the real interest rate, which
is the interest rate that is adjusted by subtracting expected changes in the price level
(inflation) so that it more accurately reflects the true cost of borrowing. This interest
rate is more precisely referred to as the ex ante real interest rate because it is adjusted
for expected changes in the price level. The ex ante real interest rate is veryimportant to
economic decisions, and typically it is what economists mean when they make refer-
ence to the “real” interest rate. The interest rate that is adjusted for actual changes in
the price level is called the ex post real interest rate. It describes how well a lender has
done in real terms after the fact.
The real interest rate is more accurately defined from the Fisher equation, named
for Irving Fisher, one of the great monetary economists of the twentieth century. The
Fisher equation states that the nominal interest rate i equals the real interest rate r plus
the expected rate of inflation πe:7
i = r + πe (9)

Rearranging terms, we find that the real interest rate equals the nominal interest rate
minus the expected inflation rate:
r = i - πe (10)

To see why this definition makes sense, let’s first consider a situation in which you
have made a simple one-year loan with a 5% interest rate 1i = 5%2, and you expect
the price level to rise by 3% over the course of the year 1πe = 3%2. As a result of making

7
A more precise formulation of the Fisher equation is
i = r + πe + 1r * πe 2
because
1 + i = 11 + r211 + πe 2 = 1 + r + πe + 1r * πe 2
and subtracting 1 from both sides gives us the first equation. For small values of r and πe, the term r * πe is so
small that we ignore it, as in the text.
126 PART 2 Financial Markets

the loan, at the end of the year you expect to have 2% more in real terms—that is, in
terms of real goods and services you can buy. In this case, the interest rate you expect
to earn in terms of real goods and services is 2%:
r = 5% - 3% = 2%

as indicated by Equation 10.8

APP L I C AT IO N

What is the real interest rate if the nominal interest rate is 8% and the expected infla-
tion rate is 10% over the course of a year?

Solution
The real interest rate is - 2%. Although you will be receiving 8% more dollars at the
end of the year, you will be paying 10% more for goods. The result is that you will be
able to buy 2% fewer goods at the end of the year, and you will be 2% worse off in real
terms. Mathematically,
r = i - πe

where i = nominal interest rate = 0.08

πe = expected inflation rate = 0.10
Thus
r = 0.08 - 0.10 = - 0.02 = - 2% ◆

As a lender, you are clearly less eager to make a loan in this case, because in terms
of real goods and services you have actually earned a negative interest rate of 2%. By
contrast, as a borrower, you fare quite well because at the end of the year, the amounts
you will have to pay back will be worth 2% less in terms of goods and services—you

8
Because most interest income in the United States is subject to federal income taxes, the true earnings in real
terms from holding a debt instrument are not reflected by the real interest rate defined by the Fisher equation but
rather by the after-tax real interest rate, which equals the nominal interest rate after income tax payments have been
subtracted, minus the expected inflation rate. For a person facing a 30% tax rate, the after-tax interest rate earned
on a bond yielding 10% is only 7% because 30% of the interest income must be paid to the Internal Revenue
Service. Thus the after-tax real interest rate on this bond when expected inflation is 5% equals 2%1= 7% - 5%2.
More generally, the after-tax real interest rate can be expressed as
i11 - τ2 - πe
where τ = the income tax rate.
This formula for the after-tax real interest rate also provides a better measure of the effective cost of borrowing
for many corporations and homeowners in the United States because, in calculating income taxes, they can deduct
interest payments on loans from their income. Thus, if you face a 30% tax rate and take out a mortgage loan with
a 10% interest rate, you are able to deduct the 10% interest payment and lower your taxes by 30% of this amount.
Your after-tax nominal cost of borrowing is then 7% (10% minus 30% of the 10% interest payment), and when the
expected inflation rate is 5%, the effective cost of borrowing in real terms is again 2%1 = 7% - 5%2.
As the example (and the formula) indicates, after-tax real interest rates are always below the real interest rate defined
by the Fisher equation. For a further discussion of measures of after-tax real interest rates, see Frederic S. Mishkin, “The
Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200.
 CHAPTER 4 The Meaning of Interest Rates 127

MyEconLab Mini-lecture MyEconLab Real-time data

Interest Rate
(% annual rate)
16

12

8
Nominal Rate

Estimated Real Rate

–4

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

FIGURE 1 Real and Nominal Interest Rates (Three-Month Treasury Bill), 1953–2014
Nominal and real interest rates often do not move together. When U.S. nominal rates were high in the
1970s, real rates were actually extremely low—often negative.
Sources: : .
Carnegie-Rochester
Conference Series on Public Policy -

as the borrower will be ahead by 2% in real terms. When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
A similar distinction can be made between nominal returns and real returns. Nomi-
nal returns, which do not allow for inflation, are what we have been referring to as
simply “returns.” When inflation is subtracted from a nominal return, we have the real
return, which indicates the amount of extra goods and services that we can purchase as
a result of holding the security.
The distinction between real and nominal interest rates is important because the
real interest rate, which reflects the real cost of borrowing, is likely to be a better indica-
tor of the incentives to borrow and lend. It appears to be a better guide to how people
will respond to what is happening in credit markets. Figure 1, which presents estimates
from 1953 to 2014 of the real and nominal interest rates on three-month U.S. Treasury
bills, shows us that nominal and real rates usually move together but do not always do so.
(This is also true for nominal and real interest rates in the rest of the world.) In par-
ticular, when nominal rates in the United States were high in the 1970s, real rates were
actually extremely low—often negative. By the standard of nominal interest rates, you
would have thought that credit market conditions were tight during this period because
it was expensive to borrow. However, the estimates of the real rates indicate that you
would have been mistaken. In real terms, the cost of borrowing was actually quite low.
128 PART 2 Financial Markets

SUMMARY
1. The yield to maturity, which is the measure that most as measured by the yield to maturity. Long-term bond
accurately reflects the interest rate, is the interest rate prices experience substantial fluctuations when inter-
that equates the present value of future payments of est rates change and thus bear interest-rate risk. The
a debt instrument with the instrument’s value today. resulting capital gains and losses can be large, which
Application of this principle reveals that bond prices is why long-term bonds are not considered safe assets
and interest rates are negatively correlated: When the with a sure return.
interest rate rises, the price of the bond must fall, and 3. The real interest rate is defined as the nominal inter-
vice versa. est rate minus the expected rate of inflation. It is both
2. The return on a security, which tells you how well you a better measure of the incentives to borrow and lend
have done by holding the security over a stated period and a more accurate indicator of the tightness of credit
of time, can differ substantially from the interest rate market conditions than is the nominal interest rate.

KEY TERMS
cash flows, p. 110 face value (par value), p. 113 rate of capital gain, p. 122
consol or perpetuity, p. 119 fixed-payment loan (fully amortized real interest rate, p. 125
coupon bond, p. 113 loan), p. 113 real terms, p. 126
coupon rate, p. 113 interest-rate risk, p. 124 return (rate of return), p. 121
current yield, p. 120 nominal interest rate, p. 125 simple loan, p. 111
discount bond (zero-coupon present value (present discounted yield to maturity, p. 114
bond), p. 113 value), p. 110

QUESTIONS
Select questions are available in MyEconLab at 5. A financial adviser has just given you the follow-
[Link] ing advice: “Long-term bonds are a great investment
1. Would $175, to be received in exactly one year, be because their interest rate is over 20%.” Is the financial
worth more to you today when the interest rate is 15% adviser necessarily right?
or when it is 20%? 6. If mortgage rates rise from 5% to 10% but the expected
2. Write down the formula that is used to calculate rate of increase in housing prices rises from 2% to 9%,
the yield to maturity on a twenty-year 12% are people more or less likely to buy houses?
coupon bond with a $1,000 face value that sells 7. When is the current yield a good approximation of the
for $2,500. yield to maturity?
3. To help pay for college, you have just taken out a 8. Why would a government choose to issue a perpetuity,
$1,000 government loan that makes you pay $126 per which requires payments forever, instead of a terminal
year for 25 years. However, you don’t have to start loan, such as a fixed-payment loan, discount bond, or
making these payments until you graduate from college coupon bond?
two years from now. Why is the yield to maturity nec- 9. Under what conditions will a discount bond have a nega-
essarily less than 12%? (This is the yield to maturity on tive nominal interest rate? Is it possible for a coupon bond
a normal $1,000 fixed-payment loan on which you pay or a perpetuity to have a negative nominal interest rate?
$126 per year for 25 years.)
10. True or False: With a discount bond, the return on the
4. Do bondholders fare better when the yield to maturity bond is equal to the rate of capital gain.
increases or when it decreases? Why?
 CHAPTER 4 The Meaning of Interest Rates 129

11. If interest rates decline, which would you rather be the mid-1980s than in the late 1970s. Does this make
holding, long-term bonds or short-term bonds? Why? sense? Do you think that these economists are right?
Which type of bond has the greater interest-rate risk? 13. Retired persons often have much of their wealth placed
12. Interest rates were lower in the mid-1980s than in in savings accounts and other interest-bearing invest-
the late 1970s, yet many economists have commented ments, and complain whenever interest rates are low.
that real interest rates were actually much higher in Do they have a valid complaint?

APPLIED PROBLEMS
Select applied problems are available in MyEconLab at 21. Consider a coupon bond that has a $900 par value and
[Link] a coupon rate of 6%. The bond is currently selling for
14. If the interest rate is 15%, what is the present value of $860.15 and has two years to maturity. What is the
a security that pays you $1,100 next year, $1,250 the bond’s yield to maturity (YTM)?
year after, and $1,347 the year after that? 22. What is the price of a perpetuity that has a coupon of
15. Calculate the present value of a $1,300 discount bond $70 per year and a yield to maturity of 1.5%? If the
with seven years to maturity if the yield to maturity is 8%. yield to maturity doubles, what will happen to the
16. A lottery claims its grand prize is $15 million, payable perpetuity’s price?
over 5 years at $3,000,000 per year. If the first pay- 23. Property taxes in a particular district are 2% of the
ment is made immediately, what is this grand prize purchase price of a home every year. If you just pur-
really worth? Use an interest rate of 7%. chased a $150,000 home, what is the present value of
17. What is the yield to maturity on a $10,000-face-value all the future property tax payments? Assume that the
discount bond maturing in one year that sells for house remains worth $150,000 forever, property tax
$9,523.81? rates never change, and a 4% interest rate is used for
discounting.
18. What is the yield to maturity (YTM) on a simple loan
for $1,500 that requires a repayment of $15,000 in five 24. A $1,100-face-value bond has a 5% coupon rate, its
years’ time? current price is $1,040, and it is expected to increase
to $1070 next year. Calculate the current yield, the
19. Which $10,000 bond has the higher yield to maturity, expected rate of capital gains, and the expected rate of
a twenty-year bond selling for $8,000 with a current return.
yield of 20% or a one-year bond selling for $8,000
with a current yield of 10%? 25. Assume you just deposited $1,250 into a bank account.
The current real interest rate is 1%, and inflation is
20. Consider a bond with a 6% annual coupon and a face expected to be 5% over the next year. What nominal
value of $1,000. Complete the following table. What rate would you require from the bank over the next
relationships do you observe between years to matu- year? How much money will you have at the end of
rity, yield to maturity, and the current price? one year? If you are saving to buy a fancy bicycle that
currently sells for $1,300, will you have enough money
to buy it?
Years to Yield to Current
Maturity Maturity Price
2 4%
2 6%
3 6%
5 4%
5 8%
130 PART 2 Financial Markets

DATA ANALYSIS PROBLEMS

The Problems update with real-time data in MyEconLab and
are available for practice or instructor assignment.
1. Go to the St. Louis Federal Reserve FRED database, (DFII10)
and find data on the interest rate on a four-year
auto loan (TERMCBAUTO48NS). Assume that you (DFII20)
borrow $20,000 to purchase a new automobile and
that you finance it with a four-year loan at the most
recent interest rate given in the database. If you (DFII30)
make one payment per year for four years, what will a. Following the Great Recession of 2008–2009,
the yearly payment be? What is the total amount the 5, 7, 10, and even the 20 year TIIS yields
that will be paid out on the $20,000 loan? became negative for a period of time. How is
this possible?
2. The U.S. Treasury issues some bonds as Treasury b. Using the most recent data available, calculate
Inflation Indexed Securities, or TIIS, which are bonds the difference between the yields for each of
adjusted for inflation; hence the yields can be roughly the pairs of bonds (DGS5 – DFII5, etc.) listed
interpreted as real interest rates. Go to the St. Louis above. What does this difference represent?
Federal Reserve FRED database, and find data on the c. Based on your answer to part (b), are there
following TIIS bonds and their nominal counterparts. significant variations among the differences
Then answer the questions below. in the bond-pair yields? Interpret the magni-
tude of the variation in differences among the
(DFII5) pairs.

WEB EXERCISES
1. In this chapter, we discussed long-term bonds as if bond by using the financial calculator at [Link]
there were only one type, coupon bonds. In fact, inves- .[Link]/indiv/tools/tools_savingsbondcalc.htm.
tors can also purchase long-term discount bonds. A To compute the values for savings bonds, read the
discount bond is sold at a low price, and the whole instructions on the page and click on Get Started. Fill
return comes in the form of a price appreciation. You in the information (you do not need to fill in the Bond
can easily compute the current price of a discount Serial Number field) and click on Calculate.

WEB REFERENCES
[Link] [Link]
Under Rates & Bonds, you can access information on key A review of the key financial concepts: time value of money,
interest rates, U.S. Treasuries, government bonds, and annuities, perpetuities, and so on.
municipal bonds.

WEB APPENDICES
Please visit the Companion Website at [Link] Appendix 1: Measuring Interest-Rate Risk: Duration
.[Link]/Mishkin to read the Web
appendix to Chapter 4.